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A World Bank report
to be released next week warns of an economic crisis in China unless
state-run firms are scaled back. The Wall Street Journal discusses the report
in New Push for Reform in China

An exclusive preview
of an economic report on China, prepared by the World Bank and government
insiders considered to have the ear of the nation's leaders, offers a
surprising prescription: China could face an economic crisis unless it
implements deep reforms, including scaling back its vast state-owned
enterprises and making them operate more like commercial firms.

"China 2030," a report set to be released Monday by the bank and a
Chinese government think tank, addresses some of China's most politically
sensitive economic issues, according to a half-dozen individuals involved in
preparing and reviewing it.

The report warns that China's growth is in danger of decelerating rapidly and
without much warning. That is what has occurred with other highflying
developing countries, such as Brazil and Mexico, once they reached a certain
income level, a phenomenon that economists call the "middle-income
trap." A sharp slowdown could deepen problems in the Chinese banking
sector and elsewhere, the report warns, and could prompt a crisis, according
to those involved with the project.

It recommends that state-owned firms be overseen by asset-management firms,
say those involved in the report. It also urges China to overhaul local government
finances and promote competition and entrepreneurship.

China's Difficult
Transition From an Unsustainable Growth Model

Peak oil, a housing bubble, bad debts and over-reliance on investments with
no genuine economic feasibility guarantee China's current boom is not
sustainable. China bulls are in for a ride awakening when various bubbles
pop.

As for recommendations, the report proposes a sharp increase in the dividends
that state companies pay their owner (the government) in order to boost revenue
and pay for new social programs.

Does China need to increase competition, break apart, and privatize the
state-owned monopolies?
Or should China simply increase the dividends?

I vote for the former as does Michael Pettis at China Financial Markets.

Via email, Pettis says:

The report is good as
far as it goes, but it doesn’t go far enough. Of course increasing SOE
dividends to the government for use in social programs will transfer wealth
from the state sector to the household sector, but if the total profitability
of the SOE sector is less than one-fifth to one-eighth of the direct and
indirect subsidies transferred from the household sector, as I have argued
many times, then even 100% dividends is not enough to slow the transfer
significantly, and remember the transfers have to be reversed, not merely
slowed. This proposal falls in the better-than-nothing category, but just.

What we really need are much more dramatic transfers, for example wholesale
selling of assets, with the money used either to clean up bad loans or
delivered directly to households. According to the article, however,
“neither the World Bank nor the DRC proposed privatizing the
state-owned firms, figuring that was politically unacceptable.”

This is the problem. The best solution for China, economically, seems to be
off limits because it will be politically difficult. In that case the second
best solution, a gradual build-up of government debt as growth slows for many
years, is the most likely outcome.

And how much will growth slow? The World Bank report apparently doesn’t
say, but the consensus has been slowly moving down towards 5-6% annual growth
over the next few years.

That’s better than the crazy numbers of 8-9% most analysts were
predicting even two years ago (and some still are), but it is still too high.
GDP growth rates will slow a lot more than that. I still maintain that
average growth in this decade will barely break 3%. It will take, however, at
least another two or three years before a number this low falls within the consensus
range.

And by the way when it does, metal prices should fall sharply. Copper prices
have done reasonably well in the past few months as Chinese buyers have
restocked, as we suggested might happen to our clients last fall. With the
recent easing we may see more strength in copper over the next month or so,
but I have little doubt that within two or three years copper prices are
going to be a whole lot lower than they are today. Chineseinvestmentdemandsimplycannothold up muchlonger.

Sad State of
Political Acceptability

The report makes feeble recommendations to ensure the proposals are
"politically correct". This is a bad practice for three reasons.

1.You only damage your own credibility

2.You presume perhaps incorrectly what is politically
acceptable

3.You plant false hope that incorrect solutions will
work, when it's clear they will not

It would be far better list the alternatives and the limitations of those
alternatives, then provide an honest assessment rather than assume something
cannot be done. Unfortunately, telling people what they want and expect to
hear is the sad state of political pandering everywhere.